The subprime rescue operation mounted by the Federal Reserve came too late for Aussie markets last week. The ASX/200 lost 3.7% on Friday to close at 5,936. The All Ords fared poorly too, shedding 222 points and 3.6% for the day. What will this week bring?

The big question in the local market is whether or not the distress in the financial markets will spill over into the demand for real assets. If the stock market is forecasting a recession, then demand for base metals and energy should fall. The stock market, however, is still up on the year. Without a bigger decline, say a 10% crash in one day, it’s hard to say with conviction that the stock market is predicting a recession.

Besides, the world’s central banks are bailing out the world’s so-called capitalists. You can throw financial stocks into the long list of institutions that are apparently “too big to fail” in today’s world. The Fed proved that Friday when it stepped in to bail out people who failed to correctly model the risks of making or owning loans to risky borrowers.

Early Friday morning in New York, the Federal Reserve stepped calmly into the fray as a buyer of last resort. A buyer of what? Mortgage-backed securities, the market that’s been causing everyone so much grief.

The Fed released a statement, announcing that, “The Federal Reserve will provide liquidity to facilitate the orderly functioning of financial markets….In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.”

On the surface, the Fed’s action seemed to reassure investors. It “injected” US$38 billion in cash into the financial system, accepting mortgage-backed bonds as collateral from institutions that were having trouble borrowing from the usual sources. In other words, the Fed accepted the toxic mortgage-related debt that no one else in the world wants to touch, and loaned out cash against that collateral. It literally brought liquidity to a market which had basically stopped trading. Think of it as an upper-class pawn-shop for well-dressed bankers.

You could almost hear the collective exhale from Wall Street, as the market dodged another red day full of distressed selling. A lot of people who needed a drink probably had one. Or two.

In Latin, delirium tremens means “trembling madness.” In medicine, it describes the condition of a drunk who needs a drink. The dictionary defines it this way, “A serious alcohol-withdrawal syndrome observed in persons who stop drinking alcohol following continuous and heavy consumption. It involves profound confusion, hallucinations, and severe nervous system over-activity, typically beginning between 48 and 96 hours after the last drink.

The Fed has given the market a stiff drink to off-set the symptoms of credit withdrawal. As any good drunk will tell you, a drunk is always a drunk, even if he stops drinking. There is no cure for addiction, just a replacement of bad habits with better habits. Below the surface, what exactly has the Fed done and what does it mean for this week?

The unusual aspect of the Fed’s actions last week was its willingness to accept mortgage-backed collateral for its short-term lending. In three separate operations, the Fed added US$19, US$16, and US$3 billion in cash to the market through its open market operations. When it loans money for short periods of time, the Fed will accept either US Treasury bonds or government agency securities (Fannie Mae and Freddie Mac bonds) as collateral.

The fact that it went out of its way to accept mortgage-backed bonds as collateral shows you what the real intention of the Fed’s actions was: to avert more panic selling and liquidation of portfolios to raise cash in the hedge fund market. Even though the Fed bought the market a reprieve, it didn’t solve the fundamental problem facing the US$2 trillion subprime market.

No one really knows what the bonds are worth because there aren’t any buyers (although that might give us a hint of what the market really thinks the bonds are worth). It is one thing for the Fed to accept them as collateral for short-term loans. It is quite another thing for real buyers to emerge in the market.

The Fed hasn’t cleared up the fundamental problem facing the credit markets. It’s only bought some time for the most distressed players. They have time, but what they still lack is a liquid market for the formerly high-yield securities which used to be so popular. What should we do with this time? Well for one, we shouldn’t assume it will last long.

It will be an interesting battle between buyers and sellers this week. Traders with nerve will be tempted to load up on the high-yield blue chip stocks that funds dumped last week. The funds dump blue chips to raise cash because they can. It’s much easier to sell Citigroup (NYSE:C), GE (NYSE:GE), Macquarie (ASX:MBL), or BHP (ASX:BHP) than to sell exotic financial instruments these days. Hence the selling.

Is it time to be a blue chip buyer or is it better to be in cash? Well that depends on how troubled the market really is by the subprime mess. Here’s the thing, though. The sub-prime meltdown has shown us that the whole class of exotic financial instruments that became so popular in the last ten years is difficult to value and even more difficult to trade. The value of the collateral in the mortgage market, for example, has upset the whole apple cart in the mortgage-backed bond market. How will other asset-backed securities fare?

Markets have consistently underestimated the seriousness of the subprime situation. It’s possible that most conventional models simply don’t account for the kind of human instincts that take over in a panic. There could be a lot more selling, the kind that not even a central bank can prevent.

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

The subprime default rate while serious, is but a symtom of the broader illnesses that you have documented, lamented , cursed and lampooned. The key point is that risk aversity will reduce the velocity of money and this will significantly impact global growth. As an aside, I expect growing defaults in the securitised debt market has to impact 1) superannuation / penion schemes 2) public sector intitutions that invested heavily in this market and 3) the issuing financial institutions that have capital guaranteed much of the AAA and AA debt. I’m sticking to cash as best I can. You are… Read more »

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